Sunday, February 15, 2015

All the gimmicks lenders press on borrowers to maintain the artifice that the loan is being serviced are financial frauds.

Sometimes the best way to summarize a complex situation is with an analogy. The Greek debt crisis, for example, is very much like the subprime mortgage crisis of 2007-08.

As you might recall, service workers earning $25,000 annually got $500,000 mortgages to buy McMansions in subprime's go-go days. The applicant fudged a bit here and there on income and creditworthiness, and lenders reaping huge profits from originating and selling mortgages were delighted to ignore prudent underwriting standards and stamp "low-risk" on the mortgage because it was quickly sold to credulous investors.

The bank made its money in transaction and origination fees, and passed the risk of default on to investors who accepted the fraud that the loan was low-risk.

The loan was fundamentally imprudent and risky because the borrower was not qualified for a loan of such magnitude. But since the risk was distributed to others, the banks ignored the 100% probability of eventual default and skimmed the profits upfront.

Greece was the subprime borrower, and its membership in the euro gave the banks permission to enter the credit rating of Germany on Greece's loan application. Though anyone with the slightest knowledge of Greece's economy knew it did not qualify for loans of such magnitude, lenders were happy to offer the loans at interest rates close to those of Greece's northern neighbors, and then sell them as low-risk sovereign debt investments.

In effect, the banks were free-riding the magical-thinking belief that membership in the euro transformed risky borrowers into creditworthy borrowers.

It's as if the $25,000/year worker wrote in a rich cousin's sterling credit score on his mortgage application. The lender and applicant conspired to fudge the numbers to lower the apparent risk of the loan. In the case of Greece, Greece and the lenders each fudged the numbers; there was no real penalty for doing so, and the rewards for doing so were substantial.

Marginal borrowers eventually default, and sure enough, both the subprime borrower and Greece soon defaulted. Life isn't perfect; people lose their jobs, get divorced, have medical emergencies, etc., and recessions lower GDP and national income.

Prudent lenders make allowances for these risks. But lenders who make big money originating loans and offloading them to others have no incentive to be prudent; rather, they have every incentive to make as many loans as they can, as quickly as they can, to maximize their profits.

Faced with massive writedowns, the lender has two choices: it can loan the defaulting borrower more money, with the explicit guarantee that the borrower will use the money to pay interest on the original mortgage. The total loan amount goes up, but the loan stays on the books at full value.

Or the lender can roll the mortgage into a lower-interest loan, effectively entering partial forbearance: the promised return on the mortgage plummets, but as long as the borrower makes small monthly payments, the loan stays on the books at full value.

Both of these strategies have been deployed in Japan for decades to keep impaired debts on the books at full value.

The last choice is to turn the mortgage into a zombie loan: the loan is neither written off nor listed as being in default: it enters a zombie state, not in good standing but not in default, either. The mortgage can stay in this netherworld for years, as the lender waits for the market to rise enough that the house can be sold without the lender absorbing a huge loss on the mortgage.

Unfortunately for buyers of sovereign debt, there is no house that can be sold to pay down the debt. Lenders can demand the debtor-nation sell off its assets to make good on the loans, but there is little recourse should the debtor-nation refuse.

When the borrower can barely make the monthly payment, he becomes a zombie. The loan principal barely budges, and so the future is unending penury. The borrower can cut expenses--bike to work, only eat beans and rice, only buy thrift-store clothing, etc.,--but this austerity doesn't change anything: he still can't afford the loan.

This is why austerity is a fake solution: no matter what the guy earning $25,000 a year does, he will never be able to pay down the $500,000 mortgage.

Meanwhile, the poorly constructed McMansion is falling apart. The loan didn't boost the borrower's productivity, or create a new income stream; the borrowed money was squandered on something that did nothing for the borrower that something much, much cheaper could have done just as effectively.

What did Greece get for its $300+ billion in debt? Did it transform the lives of all citizens for the better, fix all its dysfunctional systems, and build an economy for the 21st century? No; the borrowed money simply masked the dysfunctional systems and allowed the Status Quo kleptocracy to reap fortunes.

Greece's lenders want to keep the imprudently issued loans on the books at full value.They followed the strategy of loaning Greece more money, but only to make the interest payments. Now there is fevered talk of some version of partial forbearance: rolling the debt into new loans, perhaps writing off a chunk of the debt, etc.

None of this changes the fundamental fact that Greece was unqualified to borrow that much money. No matter what the guy earning $25,000 a year does, he will never be able to service the $500,000 debt in a way that frees him from zombie servitude to the lender.

So the hapless subprime borrower with the crumbling McMansion and Greece both have the same choice: decades of zombie servitude to pay for the crumbling structure, or default and move on with their lives.

All the gimmicks lenders press on borrowers to maintain the artifice that the loan is being serviced are financial frauds. They are simply new frauds piled on the initial fraud of issuing a visibly imprudent loan. The borrower was not creditworthy and the lender should never have offered him loans of that magnitude and at that low interest rate. The losses belong to the lenders, period.

Get a Job, Build a Real Career and Defy a Bewildering Economy(Kindle, $9.95)(print, $20)Are you like me?Ever since my first summer job decades ago, I've been chasing financial security. Not win-the-lottery, Bill Gates riches (although it would be nice!), but simply a feeling of financial control. I want my financial worries to if not disappear at least be manageable and comprehensible. And like most of you, the way I've moved toward my goal has always hinged not just on having a job but a career.

You don't have to be a financial blogger to know that "having a job" and "having a career" do not mean the same thing today as they did when I first started swinging a hammer for a paycheck.

Even the basic concept "getting a job" has changed so radically that jobs--getting and keeping them, and the perceived lack of them--is the number one financial topic among friends, family and for that matter, complete strangers.

"I want to thank you for creating your book Get a Job, Build a Real Career and Defy a Bewildering Economy. It is rare to find a person with a mind like yours, who can take a holistic systems view of things without being captured by specific perspectives or agendas. Your contribution to humanity is much appreciated."Laura Y.Gordon Long and I discuss The New Nature of Work: Jobs, Occupations & Careers (25 minutes, YouTube)

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